Fixing the “too big to fail” problem

Too big to fail

Fannie and Freddie became so large that their failure would reverberate around the US financial sector, and housing market, eventually spilling over into global financial markets and possibly the global economy. Well that’s the theory. This was the same theory that saw the bailout of LTCM and the bailout/predatory takeover (choose your own spin) of Bear Stearns.

“A failure [of Fannie and Freddie] would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance,” Paulson said at a press conference in Washington. “And a failure would be harmful to economic growth and job creation.”

All told, the two firms have racked up about $12 billion in losses since last summer.

What the bailout involves

Injection of large amounts of capital through senior preferred stock with expected ultimate ownership of up to 79.9% of each company.

Remove ordinary shareholder control, voting and dividends.

Following on from this, all lobbying and charitable contributions will stop.

Fire CEOs of both companies (although they will act as consultants for a period of time to ease the transition)

Reduce the size of the companies dramatically over the coming years

Point 5 will partially be achieved through the US Treasury purchasing CMBS from Fannie and Freddie

Smaller so you can fail

The most interesting of these is point 5. Initially, the plan allows for an expansion of loans in order to calm the real estate market itself. However, after that initial phase, both companies will be deliberately shrunk to a size where, presumably, they would be allowed to fail.

This reflects a loss of appetite of the US Government to bail out companies who take on excessive risk because Uncle Sam will be ready to catch them. The S&L crisis of the 80s, LTCM, Bear Stearns and now Fannie and Freddie would otherwise create a stronger risk appetite amongst investors.

Many small, correlated companies are too dependent too fail

Until little more than a year ago, it was widely believed that real estate markets in different countries, different states and different cities were sufficiently unrelated such that having a diversified portfolio of real estate loans or CMBS would provide sufficient protection. Given how all these markets went up strongly together, that was always a surprising conclusion.

Fannie and Freddie’s size, “too big to fail”, ensured that the US Government would almost certainly need to bail them out, and thus bail out the entire industry to a large extent. Perhaps the new US moves will ensure that smaller businesses will recognise their interdependence to the rest of their industry and make decisions with a little more care.

Of course, if the now ex-CEOs of Fannie and Freddie has expressed caution five years ago, they probably would have been fired for not taking advantage of the opportunity.